If you were an investor over the past few years looking for a strategy that would protect your capital and minimize overall risk, investing in any of the major stock markets around the world would have resulted in significant losses. Most major developed equity markets were down more than 20 percent in Canadian dollar terms in calendar year 2008 alone, while small capitalization equities or emerging market equities posted returns in the -40 to -50 percent range over the same period. Although equity markets have faired better so far in 2009, high volatility and poor liquidity remain key concerns.

So, is turning to cash or fixed income the solution then? Well, yes, it could be if your time horizon is fairly short. However, this does not necessarily represent a suitable solution for those investors who are in for the mid to long haul.

Following periods of great underperformance from equities relative to fixed income, equities have been known to rebound significantly, leaving investors that took cover into cash or fixed income well behind those preferring equities. One recent example is the post-tech bubble period of 2000-2003. For instance, from 2000 to 2002, U.S. equities fell behind U.S. fixed income on average by over 20 percent, only to see equities outperform fixed income by almost 25 percent in 2003 alone, most of which occurred in the last three quarters of the year.

The widely accepted notion that the majority of value added is typically generated by a portfolio’s asset allocation is even more prevalent now. As such, gaining exposure to various asset classes with low or negative correlation should be the main focus of a sound investment strategy.

One of the problems that many retail investors face is the fact that asset classes with lower correlation were generally found in the more non-traditional areas of the market, areas sometimes difficult to gain exposure to via active management. Let’s take, for example, emerging markets. A retail investor may find it a hard task to trade securities in Brazil or Russia in order to diversify a portfolio of Canadian or U.S. securities.

The introduction and strong growth of exchange traded funds (ETFs) over the past few years have made asset allocation for the sake of diversification available to all types of investors. It is now possible for investors to be exposed to a number of asset classes (for example: bonds, equities), sectors (energy, real estate), regions (BRIC, EMU), countries (Hong Kong, Peru, Canada), commodities (gold, silver), investment styles (value, growth), capitalization (small, mid, large), and more.

ETFs present a number of advantages to all investors. First, ETFs are publicly traded and therefore can be transacted at any given time. This characteristic makes them extremely flexible and easy to use even for less seasoned investors.

The underlying investments of ETFs are transparent, as they typically follow known indexes. While a mutual fund may only publish its top holdings on a monthly or quarterly basis, the index provider may make the holdings of its index, in which the ETFs invest, available more frequently.

Because of their structure, ETFs are fairly inexpensive to operate and therefore can be offered at a lower cost to investors. In most cases, their expense ratios are often smaller than a typical mutual fund–even mutual funds with indexed management.

The indexed structure of an ETF generally implies that turnover within the ETF is minimal, thereby generating a relatively low number of taxable events. In addition, if managed properly, an ETF can lower capital gains by swapping stocks that are coming out of the index with those that are being introduced into the index (a non-taxable event). Ultimately, an investor can decide to sell an ETF when it is fiscally advantageous for him or her.

On the other hand, ETFs remain primarily indexed investments, not expected to add a large amount of value relative to the benchmark they are tracking. However, from an asset allocation angle, the exposure to ETFs is often all that is needed.

Finally, as the number of ETFs increases, so, generally, does their complexity and cost. New ETFs with exotic features, such as leverage, have started making their way into the marketplace.

As market participants continue their quest for the ideal investment solution, the use of specific ETFs, combined with actively managed strategies, can be part of a sound long-term plan. ETFs allow investors to gain access to asset classes they would not otherwise have access to through an actively managed solution. ETFs are flexible, reliable, and affordable.